The Markets Reward Actual Truths, Not Investor Biases

We take eye exams to ensure our vision doesn’t degrade, requiring corrective measures.

With investing, categories are critical to how we see the world. To maintain a clear view of evolving risks and opportunities, we should be intentional in periodically examining them.

Life Before Nutrition

“There was no ‘nutrition’ when we grew up,” recalls Jerry Seinfeld on a recent Netflix special. “I would roll out of bed and do a swan dive into bowls of Coco-Puffs, Lucky Charms, Fruit Loops, Sugar Pops. I’m getting light headed right now actually, thinking about it.”

I don’t know about you, but I can relate to what Jerry is talking about.

Saturday morning, 1980-something, my butt was planted in front of a TV. Downing my morning sugar fix, I was transfixed not only by the cartoon lineup, but also by the commercials that accompanied them. That’s when Tony the Tiger and Captain Crunch made an appearance.

Because of those commercials, trips to the supermarket became an event. The cereal aisle was my aisle, where I got my first taste of what it meant to be a consumer, pledging loyalty to a brand.

Thirty-something years later, I’m a father of two young boys who don’t watch commercials. They stream shows on Amazon and Netflix. The only reason they know about Coco-Puffs is because their Dad still sometimes eats them.

It’s a different world. 

If you’re an investor, it pays to notice when the world changes. I know that sounds painfully obvious, but it’s not always as easy as it sounds.

The Dangers of “Confirmation Bias”

We’re all prone to a tendency known as “confirmation bias.” We unconsciously seek confirming evidence of the ways we already interpret the world. Meanwhile, we tend to reject new information that conflicts with our existing beliefs.

Markets reward underlying truths, not our biases or entrenched beliefs. To help overcome your bias, and invest more wisely as a result—pay attention to how you categorize.

Throughout life, we are better equipped for relative thinking than absolute thinking.

Categories are heuristic shortcuts we use to process information more efficiently. We relate everything we encounter to other things we already understand, and from an early age, begin to group things we deem to be similar.

If you’ve ever stared at a baby and felt they looked a bit clueless—well, it’s because they are! They haven’t formed these connections yet.

Investors routinely categorize investments. Size, sector, and many other factors are considered. ETFs (exchange-traded funds) are growing more popular by the day, and are created based on such criteria. As evidence for just how important categories are to the modern landscape, consider the fact there are now more indices to group stocks by than there are stocks themselves.

Let’s walk through some examples of how categories can change over time.

Category #1: Consumer Staples

Firms populating this sector generally make or sell products that are a “staple” of daily life. You use them frequently, independent of how the economy fluctuates. The sector has historically been perceived as low-risk.

Within the sector, the biggest firms have historically maintained high market share. Blue-chip names like Coca-Cola and Procter & Gamble have consistently garnered premium valuations, owing to their reputation as reliable compounders. Scale advantages in distribution and media channels enabled them to maintain premium shelf-space, strong brand equity, and consistently high profit margins.

Steady and ever-increasing cash flow resulted in healthy returns for shareholders.

Take cereal giant Kellogg, for example. From the time I, like Jerry Seinfeld, started eating their delicious sugary cereals for breakfast – around 1981, through the year I went away to college (1997), Kellogg’s stock returned 23% per year, beating the S&P 500 by about 600-basis points annually.

Since then, however, Kellogg’s competitive advantages have gradually receded, as has the stock’s relative return profile.

The world now seems a lot more uncertain for major consumer product companies. Kellogg isn’t alone in that battle. P&G CFO Jon Moeller said on a conference call earlier this year: “There are probably more sources of volatility today than at any other time in history.”

Category #2: FANGs

In recent years, a category of tech behemoths called the FANGs have been spreading their tentacles far and wide, nudging companies like Kellogg out of their previous pole positions with consumers.

The availability of online research has transformed the way consumers discover products, make purchasing decisions, and form brand relationships. According to tech expert Tristan Harris, Google and Facebook are no longer merely companies. They’re “vast attention cities,” designed entirely around commerce, where all of us reside.

Network effects are a common link in the DNA chain of this category, and with network effects—bigger is better. Like its FANG brethren—the bigger Google gets, the more powerful its network and data advantage becomes.

In the future, Google literally wants to “see” and “hear” your surroundings, following you everywhere you go, collecting more data than any consumer giant has ever had access to.

As data and connectivity become ever more ubiquitous in our daily life, perhaps it’s time we reinvent our view of what constitutes “staples” in the 21st century.

Adjusting Prior Thinking

Parents were slow to recategorize appropriate breakfasts for the same reason most kids didn’t wear helmets when riding their bikes 30 years ago. The issue revolved around a concept behaviorists call “anchoring.” People are slow to adjust prior thinking.

New paradigms, and the categories they engender, take time to fully form. While that’s happening, powerful investment opportunities emerge. Be on the lookout.

Today, you can buy Alphabet shares (parent company of Google) for approximately the same price-to-book multiple as Procter & Gamble. One of those companies grew book-value by 14.9% over the last year, while the other grew just 0.6%.

Meanwhile, the S&P 500 Information Technology sector trades at 19.5x forward earnings—a smidge cheaper than Consumer Staples at 19.8x.